Will 'Cliff' Woes Completely Derail the Economy?

Jason Stipp: I'm Jason Stipp for Morningstar. Recent data indicates that the economy is doing better than most people expected recently, but the fiscal cliff headlines still loom and the market is still upset about all the negotiations in Washington.

So will the fiscal cliff debate throw off what is a stronger economy today? To give his insights is Morningstar's Bob Johnson.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: So you don't want this to get lost. We got data this week that shows the economy was stronger than just about everyone expected in recent times, but the fiscal cliff headlines are still dominating, still upsetting the market. Let's talk about some of the things that looked better than they looked before. We already talked about housing this week and we know that that market is still doing well, but we got some more data this week; the GDP third revision was a lot higher than everyone thought it was going be.

Johnson: Yeah, it came up over 3%, 3.1% in terms of GDP growth, and it was a nice [reading] across, many categories did better, a couple consumption categories, imports, exports all looked better. So I really liked that that number was over 3%. That's one of the best numbers of the recovery by the way, and I think everybody was very fearful.

The bad thing about the 3.1% is that it means the fourth quarter is going to be a tougher comparison. That's the bad news.

Stipp: Do you think that it will be a tougher comparison that we will come down from that 3.1%?

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Johnson: It will come down. We won't match the 3.1%, but based on data we've seen today, I would say that we have a better chance of being over at 2% than we thought even a week ago.

Stipp: So let's talk about some of that data that's going to get wrapped up in the fourth quarter. One of them is the consumption and income reports that we got, and those looked really good.

Johnson: We've got to be a little careful, because they almost looked so good, it's probably a little bit too good to be true, and we are always subject to revision. But, we had 0.6% growth in spending and 0.8% growth in income in November. That's for one month; that's not year-over-year. So you annualize those numbers, and you get numbers that are between 7% and 10% for year-over-year growth, adjusted for inflation. Those are huge numbers, the best-of-the-recovery type of numbers.

Now some of it's, obviously, because somehow they missed something with Sandy and then things bounced back really sharply. But again, the October and September numbers for both income and expenditures were also revised upward. So that's the really interesting thing. Sometimes when you have the really good numbers is because [prior revisions] made the other numbers look worse. But they made the Sandy impact in October quite a bit less and even September was a little better, and that crept into the GDP report we saw, too.

Stipp: So these numbers are giving us a good amount of momentum, then, going into December, the last month of the fourth quarter. What kinds of bad news would we have to see in December to really counteract this good news that we had from the prior months here?

Johnson: Well, you know, if we ended up where income and consumption was flat in December, adjusted for inflation, compared to November, we would still have well over 2% growth in consumption, and that's compared to … about 1.6%, I think, in the third quarter and 1.5% in the second quarter, so some pretty strong acceleration in consumer spending, without any improvement from the November level--I'm not saying anything heroic. And then on top of it, lower gasoline prices mean a lower inflation rate, which means that we may even have a deflation number; whatever the number ends up to be, we might add a tenth to it.

Stipp: Last piece of news that we got today--it came out early, actually; it was expected next week--is durable goods. What does that tell you? It was stronger than expected as well.

Johnson: Now remember the consumer is the big thing. That's what we really care about, and that's why today's [consumption and income] report was so dramatic and why everybody is racing to the drawing board to raise their GDP estimates for the fourth quarter.

But business and investment spending is also 15% of GDP, probably the next-largest category, and everybody was fearful with the fiscal cliff hanging over our head and there was some talk that businesses were cutting back. Lo and behold, orders have been up for two months in a row now in terms of business capital spending. The shipments, which is actually the number that goes into the GDP, was revised up for October, and November looked better as well. So it now looks like, instead of being a detractor from GDP in the fourth quarter, business investing spending will be a contributor.

Stipp: So, we're building up a nice head of steam, I think, with a better-than-expected economic results, but we still do have this wrangling going on in Washington. So, first of all, I want to ask you, will this head of steam that's putting us in a better position going into these negotiations even though the outcome of those negotiations are still yet to be known…

Johnson: I'd rather be going into this with a strong economy than one that's already falling apart.

Stipp: Right, exactly. So, where we stand right now, there is still back-and-forth, there is still wrangling. Do you think that they will get a deal done before Jan. 1? And secondly, do you think it matters if they get a deal done before Jan. 1?

Johnson: I'm not as sure as confident as I once was. I do not think they'll get something by the end of the year. I think they'll get something early in next year, but I don't think they'll get it maybe by the end of the year. And my reason is that, for a while I think it looked like we had a case where it was all about the tax rate, and it looked like that would be easily soluble. Now we've brought it back to these spending questions. We're going to potentially raise taxes, but on the other hand we need to cut spending, and now that's going to require a little bit more negotiations. It's not all about taxes; it's about spending too.

Stipp: So, we have talked before about how we were measuring the fiscal cliff. How big was that whole amount of spending cuts and tax increases, and it amounts to $700 billion, if they can't reach a compromise.

Johnson: Correct.

Stipp: One of the important points you've been saying about this, though, is if they don't reach that compromise by Jan. 1, that whole $700 billion is not wiped away immediately.

Johnson: That's correct. Some of it comes over time. $110 billion of the $700 billion is sequestration. Again, government agencies being what they are, the cuts will tend to come later in the year, not all on Jan. 1. It doesn't say stop spending on Jan. 1. It says, well by the year you need to get down to this number. So, that's one example.

The taxes on investments, which are going up in a couple of different ways. Those will get paid with your [2013] taxes in April [2014]. So, those might make some difference in the way you think about things, but the actual payment of the taxes happens much later.

But there are a few things that do hit in the here-are-now, and now it looks like they're almost unavoidable, even with an agreement.

Stipp: So what are some of those things that are likely to happen? You are saying they probably will reach an agreement, it probably won't be before the end of the year, but let's talk about what the contours of the amount of [spending] cuts and tax increases you think are likely. What things are we pretty sure are going to happen, and they are going to agree on?

Johnson: Well, I've talked in the past of $170 billion worth of things out of the $700 billion that would happen. And those will happen on Jan. 1, most likely, and will show up in the Jan. 15 pay period if you're on a two-week pay period, or Jan. 7, if you're in a shorter pay period.

One is the Social Security tax, payroll tax, cut that was cut as an emergency measure in 2010; that's going to go back on again. And I think … people think it needs to go away in both parties anyway, and the way the schedule is, and the way the withholdings go, I think, it's a done deal. And that will hit, and it's not a tiny number.

Stipp: So we're going to get that.

… You actually think that, from some agreement, we're going to have a higher hit than that original $170 billion that you thought was probable. What's behind that?

Johnson: Yes.

Stipp: Why do you think that we're going to have more of a cliff, so to speak, than maybe you thought before?

Johnson: Number one, the Bush tax cuts being extended. I thought maybe they would agree on it for everybody and maybe just some very, very, very small group would get a little bit of an increase. You know what, for now, I think it'd be a lot safer assuming that people over, say, $250,000, $300,000, $400,000 do get stuck with a higher tax rate. And that probably amounts to an additional $50 billion onto the $170 billion, which is basically the payroll tax, so that brings me up to $220 billion.

And then the other one that gets a little bit complicated is there are some business benefits that are in there, the R&D tax credit, which everybody always loved, a number of other measures--depreciation and so forth--that are in there. I bet we only get half of that back now, because people will be looking for ways to cut, so that brings us up into the $260 billion or so range.

Stipp: So if that's a likely outcome from a resolution that we may get before the end of the year, we'll probably get sometime next year, will that put us into recession if we have that amount of a hit from tax hikes and spending cuts?

Johnson: Well, you know what, it depends on the environment a little bit. And I know from what we saw in 2012 that we can suffer through $200 billion in deficit reductions--that's exactly what we had in 2012--and we actually are going to end up growing the economy over 2% in 2012, so we can certainly live with that. If we creep a little bit under 2% growth, maybe we could even endure a little bit more.

Now, if we've got falling gasoline prices, which we have and we've probably peaked out in terms of food prices, now there's some other money for the consumer. We're pushing it, but $260 billion to $270 billion in my mind, we can endure. And we'll still probably get something relatively close to my 2% growth [forecast]. Now if we completely drive over this cliff, nobody talks to anybody, and all $700 billion happen somewhere during the course of the year, we will dip into a recession.

Stipp: So the bad news is, at least in the short-term, the cliff is probably steeper. It's not really a cliff, but the amount of spending cuts and tax raises that we'll see, is going to be steeper than maybe we thought before.

The good news is the economy seems to be going into this environment in a better shape than we thought before. So hopefully those two will counteract and counterbalance each other to some extent, and we can make it through next year without dipping into recession.

Johnson: Absolutely--that's what my belief is.

And I do think there's some major incentive for negotiation and it's a surprise thing, it's the alternative minimum tax [patch]. Less than 10 million people today [are subject to AMT], and we're now talking for taxes for 2012 that are due in April of 2013. [If Congress doesn't patch the AMT], people aren't going to be able to file their taxes, because they won't even know if they are subject to this tax. [If the AMT doesn't get patched] [the government is] literally going to have to come out and say, "Gee, you may have your W-2, but don't file your taxes because you may get nailed by the AMT unless we solve this thing," and then you'd have to re-file your tax returns and send in more cash. This would extend the AMT to tens of millions of additional families, and they aren't going to let that happen, so something has to move on that front, and that has to happen in the month of January.

Stipp: OK Bob. A lot of moving parts here, economic data, still wrangling in Washington, but thanks for helping us take a step back and get a sense of the landscape.

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